In the early 20th century, Carlo Ponzi defrauded investors through pyramid schemes in which money solicited from new investors was not invested as promised but instead was used to pay older investors' promised returns and to meet redemption requests. Since then, such fraudulent arrangements have been called "Ponzi" schemes. Since December 2008-with the ongoing financial crisis-Ponzi schemes have been unraveling. Prominent money managers such as Bernard Madoff, R. Allen Stanford, Paul Greenwood and Arthur Nadel have been accused of (or, in Madoff's case, admitted to) orchestrating massive frauds costing investors billions of dollars.

Ponzi losses present difficult tax issues, including whether taxes paid on phantom income can ever be recovered. On March 17, 2009, the IRS issued Revenue Ruling 2009-9 and Revenue Procedure 2009-20 to provide guidance and relief to taxpayers. In this article, we briefly highlight things advisors should know about the general tax rules for theft losses, the conclusions of Revenue Ruling 2009-9, and the provisions of the safe harbor outlined in Revenue Procedure 2009-20.
Worthless Investments

An individual taxpayer who holds stock that becomes worthless is entitled to a capital loss deduction equal to his or her unrecovered investment in the stock (that is, the taxpayer's basis). To claim the tax deduction, the loss must be evidenced by a closed and completed transaction; fixed by identifiable events; and actually sustained in the tax year. An individual can offset capital losses against capital gains realized in the same tax year and can use any unused capital loss against up to $3,000 of ordinary income in that year. Unused capital losses can be carried forward indefinitely to offset future capital gains and up to $3,000 of ordinary income per year until fully used. Capital losses cannot be carried back by individuals to prior years.

Theft Losses
A theft loss, as opposed to a worthless investment loss, is treated as an ordinary loss that can offset both ordinary income and capital gain items. A theft loss is determined under the law of the jurisdiction where the events occurred, but generally it is any criminal appropriation of another's property by swindling, false pretenses or guile with intent to deprive.
A theft loss is deductible in the year the taxpayer discovers the theft, but the theft loss deduction is reduced by the amount of any reasonable prospect of recovery. Further, if the theft relates to property not used in a trade or business and not held for investment, the deduction is significantly limited to an amount in excess of a de minimis amount ($500 for 2009; $100 thereafter) and 10% of the taxpayer's adjusted gross income (AGI).

Revenue Ruling 2009-9
In Revenue Ruling 2009-9, which can be relied on by all taxpayers, the IRS addressed the tax treatment of Ponzi losses.
First, a Ponzi scheme victim can claim the loss as an ordinary deduction arising from a theft, not as a capital loss with respect to a worthless investment.

Second, the theft loss is treated as relating to a transaction entered into for profit, so it is neither subject to the 10% AGI limitation nor subject to other limitations on itemized deductions.

Third, a victim can deduct the theft loss in the year discovered, but the loss amount is reduced by the amount covered by a claim for reimbursement or any reasonably expected recovery. Any amount that the victim actually recovers is not includable in the victim's gross income unless the recovery exceeds the amount previously set aside to reduce the theft loss. If the recovery never happens, the victim is entitled to an additional deduction in the year it is determined that there will be no recovery.

Fourth, the theft loss deduction is equal to the amount of the victim's initial investment plus the amount of any additional investments, including reinvested "profits," minus any amounts withdrawn, minus the amounts received as reimbursements or other recoveries, minus claims as to which there is a reasonable prospect of recovery. Importantly, a victim can claim a loss on phantom profits on which the victim previously paid taxes.

Fifth, to the extent the allowable theft loss is greater than the victim's income in the year claimed, the resulting net loss can be carried back three years and-if the victim does not have enough income to absorb that loss in the carryback years-can be carried forward for 20 years. The victim can choose to forgo the carryback period. For what is referred to as an "applicable 2008 net operating loss," a victim can carry such loss back for either four or five years, in accordance with the provisions of the American Recovery and Reinvestment Act of 2009.

Sixth, the victim cannot invoke the tax rules for "claim of right" or "mitigation" as alternative remedies to recover taxes paid on phantom income.

And seventh, the amount of theft loss is not taken into account in determining whether the victim has engaged in a "reportable loss" transaction of the type that must be disclosed to the IRS.

Revenue Ruling 2009-9 is generally favorable to taxpayers, but it provides limited relief to those victims with insufficient income for the year of the theft and the past three years (or up to five years if the victim is eligible for a 2008 net operating losses). Furthermore, the ruling precludes the use of claim of right and mitigation as possible avenues to seek a refund of taxes overpaid in prior years, with interest.

Revenue Procedure 2009-20
Acknowledging that the determination of whether-and when-a victim qualifies for a theft loss is highly factual and uncertain, the IRS issued Revenue Procedure 2009-20 to set out a safe harbor. Under the procedure, the IRS will not challenge a Ponzi scheme loss by a "qualified investor" who elects the safe harbor. Under the safe harbor:
The loss is deductible as a theft loss.
The theft loss is deductible in the year in which the indictment, information or complaint against the promoter of the fraudulent scheme is filed.
The amount of the claimed theft loss is initially determined in accordance with Revenue Ruling 2009-9. Next, the amount of the loss is multiplied by 95% if the victim is not seeking recovery from third parties, or by 75% if the victim is seeking third-party recovery. The amount of the deduction is reduced by the amount of any actual recovery by insurance or other recoveries available to the victim.

Advisors considering the safe harbor must weigh the size of the theft loss "haircut" (5% or 25%) against the certainty of obtaining the deduction in the correct tax year. A victim who claims a theft loss outside of the safe harbor is obviously open to IRS audit and should carefully evaluate all disclosure obligations.

Summary
While both Revenue Ruling 2009-9 and the safe harbor provide helpful guidance and relief to taxpayers, important unanswered questions must still be considered. For example, is relief available to victims who indirectly invested in fraudulent Ponzi schemes through intermediate or "feeder" funds in lieu of a direct investment in the promoter entity? The safe harbor says it is not available to these investors because they are not in direct privity with the investor promoter.
However, lawsuits have been filed against these feeder funds and their managers over their role in investing monies with Ponzi scheme promoters. To the extent the actions of those managers would constitute theft under the applicable jurisdiction for tax purposes, investors in feeder funds should be able to rely on Revenue Ruling 2009-9 or the safe harbor.

Further, under Revenue Ruling 2009-9, the Madoff scheme presents a fairly straightforward fact pattern because the theft and amount of the loss was readily identifiable. Other Ponzi scheme investments present difficult tax issues, such as whether there were both legitimate and fraudulent schemes being undertaken and whether the investor can distinguish between legitimate and fraudulent schemes.

Special considerations must be addressed for tax-exempt retirement plans, charities, private foundations and investors that are required to return (or "claw back") any proceeds received from the fraudulent investment.

The bottom line is that advisors should tread carefully if considering stepping outside of the guidance provided by Revenue Rule 2009-9 and the safe harbor.    

Andrea S. Kramer ([email protected]) and Thomas P. Ward ([email protected]) are partners in the international law firm of McDermott Will & Emery LLP, resident in its Chicago office.